Time ripe for circling vultures

Think of any lagging company and the chances are there is some M&A rumour circulating.
AFR

by
Brendon Lau

Investors hoping to reorganise their portfolios as the new year approaches by sweeping out the laggards of the past 12 months could find the task tougher than in previous years due to the wave of corporate activity expected to hit the market shortly.

Experts believe conditions are ripe for mergers and acquisitions and are tipping a sharp pick-up in corporate activity in 2011 following a relatively subdued 12 months in which there were only about $67 billion worth of transactions, compared with the six-year average of $92 billion.

This is largely because of the general absence of local bidders; private equity groups and international entities have been far more active in hunting for M&A opportunities.

But this could change, with the largest 200 Australian listed companies sitting on a record pile of cash totalling nearly $148 billion, according to Bloomberg data compiled by The Australian Financial Review. This is a 48 per cent rise on a year ago and nearly three times that held on balance sheets five years ago.

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BHP Billiton
may have pulled its hostile $US40 billion bid for Potash Corporation of Saskatchewan after it was blocked by the Canadian government, but
AMP
tabled a new cash and scrip bid for
AXA Asia Pacific Holdings
that values it at $15 billion.

Growing confidence about the economic outlook and attractive market valuations are likely to tempt company boards to spend the cash to expand their businesses, with the one-year forecast price to earnings multiple for the S&P/ASX 200 at about 14 times – a 17.6 per cent discount to its 10-year median.

Independent investment adviser Morningstar believes the market has all the hallmarks of a “vulture’s playground" with stronger players likely to circle over the weak.

“There are plenty of companies that have weathered the global financial crisis and come out the other side with a balance sheet that is in better shape than they have been for a long time," says Morningstar’s head of equities research, Peter Warnes.

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Company Profile

Think of any lagging company and the chances are there is some M&A rumour circulating.

The M&A expert from accounting firm Pitcher Partners, Rohan Filer, is not surprised by this: “There is the potential for companies, where the share prices have not been performing well, to either become part of another group or to be revived under a different capital structure."

Alcoholic beverages company
Foster’s Group
is one obvious example, and there is speculation about how the stock would be worth more if its beer and wine operations were split.

Another struggling company that could fall in the cross-hairs of a hunter is plumbing and electrical supplies company
Crane Group
.

The stock is struggling to recover from its 20-month low of $7.42, hit two weeks ago after it issued an extremely cautious outlook due to its poorly performing water division and a slower than expected recovery in construction activity.

However, Morningstar thinks that
Wesfarmers
might be attracted to the blood in the water as Crane’s bathroom retail chain Tradelink would be a good fit with the industrial conglomerate’s
Bunnings Warehouse
operations. Wesfarmers should also find little trouble in off-loading parts of the business it doesn’t want to other trade buyers.

Chief investment officer for Celeste Funds Management, Frank Villante, believes that boring is the new sexy when it comes to M&A.

“Dull but cash-generative businesses will be in vogue again in the next six to 12 months," he says.

“There has been a lot of interest quite far out on the risk spectrum and you will inevitably get some tilt back [towards] the comfort of a low multiple, good cash flow and an attractive yield."

Candidates that fit into this category include customer communication solutions firm
Salmat
and building fixtures and fittings distributor
GWA Group
, Villante says.

From a sector perspective, those that have been overlooked or are unloved due to shorter-term headwinds will be back in focus.

“This isn’t because the performance has been abysmal but more because people are focusing more on comparative sales statistics, which is coming off government stimulus."

The sector is cheap and has a bright outlook in the medium term as the health of the Australian consumer is good due to the robust fundamentals of the Australian economy. The strong local dollar is a boon as most retailers are importers.

The more likely targets in this space are niche retailers such as women’s apparel retailers
Specialty Fashion Group
and
Noni B
, Villante says. These companies have managed to overcome operational challenges and are still trading on relatively low P/Es.

“Other broader consumer discretionary plays like [home appliance distributor]
Breville Group
could also be in play," he says. “You’ve already had one [failed] bid from
GUD Holdings
, but from an international context some of Breville’s assets do look pretty attractive."

GUD, which owns the Sunbeam brand, made a bid for Breville in late 2009. The company gave up on the bid when the competition watchdog opposed the acquisition but GUD still holds a stake of about 19 per cent in Breville.
Solomon Lew
from Premier Investments is Breville’s biggest shareholder, at 30 per cent, and there is speculation he might be keen on taking over Breville as he is unlikely to meet the same opposition from the Australian Competition and Consumer Commission.

Another sector likely to become a hunting ground is property. Morningstar believes smaller, lower quality Australian real estate investment trusts (AREITs) are still trading at below net tangible asset (NTA) values and would make ideal targets for larger groups.

Warnes highlights the real possibility that ING could exit the Australian property market, and that could put
ING Industrial Fund
,
ING Office Fund
and
ING Real Estate Community Living Group
in play. There has already been some activity in this space.
Stockland
looks set to snatch up retirement village operator
Aevum,
the target’s board finally conceding to back the proposal.

Other takeover candidates on Warnes’s short-list include
Abacus Property Group
, with its good long-term potential earnings growth and over 30 per cent discount to NTA;
Australand
Property Group, as its scale and earnings stability will appeal to a larger rival;
Challenger Diversified Property Group
, with its sound portfolio metrics with about 20 per cent discount to NTA;
FKP Property Group
, as Stockland holds a 14.9 per cent stake in the group that is trading at a material discount to NTA; and
Valad Property Group
, as it has repaired its balance sheet but trades about 40 per cent below its NTA.

Healthcare facility operators are also potential targets following the fall of
Healthscope
into private equity hands.

“Healthcare has been a playground for both private equity and operators within the sector," Warnes says.

“Healthscope is a classic because it has real estate assets that can be put into a property trust and its operating assets can be funnelled into another unit."

The same structure could apply to
Ramsay Health Care
in Warnes’s opinion, but any deal would need the blessing of chairman Paul Ramsay as he holds a 36 per cent stake in the hospital operator.

But pathology and radiology services group
Sonic Healthcare
has an open register, and the slide in its share price following a disappointing 2009-10 profit downgrade makes it a more probable target for private equity interests as its balance sheet has room to be leveraged up in debt.

Private equity has also been active in the financial services sector with KKR making an overture for fund manager
Perpetual
last month.

“Market volatility post the GFC has impacted on sentiment and valuation, but in the longer term, the domestic economy is in good shape and we’ve got compulsory superannuation," says Villante. “I think there will be more interest in some of the asset managers, financial service players and even accounting businesses."

A review of commissions in the financial planning space could trigger consolidation in the sector,
WHK Group
and
Count Financial
potentially playing it both ways, either as an acquirer of smaller businesses or a merger candidate.

Count could also move on independent mortgage broker
Mortgage Choice
, as it has a 17 per cent holding in the company.

The same could happen to
Iress Market Technology
, as the
ASX
holds a 19 per cent stake in the trading systems provider.

But the ASX is probably too distracted in the near term to think about Iress as it is trying to win support to merge with the Singapore Stock Exchange.

IOOF Holdings
and
Insurance Australia Group
(IAG) have not been spared by the rumour mill either.

IOOF recently merged with Australian Wealth Management and the enlarged group is believed to be an enticing proposition for a larger rival if it can appease the ACCC. This means a foreign entity looking to gain entry into the Australian market is more likely to be running a ruler over the business.

IAG has lost favour with investors due to problems with its UK business.
QBE Insurance
Group has knocked once and IAG’s key shareholders may be more open to an approach now, noted Warnes.

The resource space has had its fair share of corporate activity and this is likely to continue.

Morningstar thinks
Whitehaven Coal
could be next to go following South-East Asia-based Banpu Minerals’ takeover of
Centennial Coal
.
Oz Minerals
and
Equinox Minerals
may also be coveted for their quality assets, while intense interest in goldminers is likely to mean further consolidation following
Newcrest Mining
’s takeover of
Lihir Gold
.

However, experts warn investors shouldn’t be hung up on M&A, as holding a poor-quality stock in hope of a takeover bid will more than likely lead to tears. Investors should only contemplate sticking to an out of favour stock if the challenges facing the company are temporary.

The other thing to be aware of is how M&A can temporarily distort the market as the weak are rewarded and the strong punished. Don’t be surprised if laggards outperform better quality stocks in the short-term as the share price of a bidder normally falls while the share price of the target rises.